Below Microsoft's Surface; Winners And Losers In The Tablet Wars

Jul. 3.12 | About: Microsoft Corporation (MSFT)

Now that tablets are eating into the PC market, it's no wonder that a veritable land grab has started in the latter. First Apple Inc. (NASDAQ:AAPL), then the Android tablets by the likes of Samsung (OTC:SSNLF), Dell Inc. (NASDAQ:DELL), Toshiba Tec Corporat (OTC:TSHTF) and others, then, Inc. (NASDAQ:AMZN), followed by Microsoft Corporation (NASDAQ:MSFT) and now Google Inc. (NASDAQ:GOOG), apart from producing the Android software, is taking a swing at the hardware. And we're not even counting Research In Motion Limited (RIMM), which had an early entry with the playbook, or Motorola's Xoom tablet (now part of Google).

Why tablets
Simple really. Apple finally made the concept work. Tablets are mobile entertainment devices, which Apple finally made desirable enough for the market to launch, adding its signature design, seamless working software, and unprecedented retina display to boot in the latest version.

Here is Jason Hiner from techrepublic:

For tens of millions of people, using a tablet like the iPad is infinitely easier and less frustrating than dealing with a Windows laptop. That's why tablets are eating the bottom out of the PC market, and the trend is accelerating

Tablets are easy to operate, instant on, portable and handy companions, although in the latter capacity, they're trumped by smartphones, which get bigger and sharper displays. As we've already explained in two previous articles, businesses are also becoming keenly aware of the possibilities of tablets.

Business applications are rapidly increasing; consider the following:

A surprising amount of companies are using iPads, with Apple saying last October that 93% of Fortune 500 companies have deployed or are testing iPads. Considering that it usually takes forever for technology to be adopted in the workplace, the iPad has gained traction with CEOs bending IT departments to their will. No doubt we will see even more companies getting interested in the device with this new edition.

It isn't hard to figure out why. Think of pilots having flight manuals; sales people having client records; product documentation, and catalogs; doctors with full medical details about patients at their fingertips, and it will become clear that the possibilities are rather endless.

Even in business, Apple's tablet is becoming a threat to Microsoft, which is realizing the threat, according to Jason Hiner from techrepublic:

It also knows that an alarming number of companies are allowing their employees to use iPads and some are even running trials to hand out iPads to many highly mobile employees. What's even worse for Microsoft is that most of these employees are loving it and are gladly chucking their Windows laptops aside.

Microsoft had to do something to fight back, as business is the territory of its main advantage and profits. With so many legacy business applications running on Windows, it's very loath to see Apple make inroads here. Indeed:

Unlike the Apple iPad and the various Google Android devices on the market, the Surface seems to be aimed at the business market. The Surface has a keyboard that a secretary could actually write a report on. There's also an upgraded version of it that can actually run Windows XP software. Vast numbers of businesses still use XP applications and even XP as an operating system. That means Microsoft should be able to sell large numbers of these devices to corporate and government customers. [Motley Fool]

These corporate and government customers are also the most profitable for the software. The tablet/PC unifying new operating system Windows 8 gives Microsoft the ability to more or less seamlessly integrate the tablet and the PC, boosting Windows 8 itself.

Therefore, Microsoft came up with the 'Surface,' actually two versions of that. The first runs on ARM type chips and the version of Windows 8 (RX) that has been designed for that. The second version (the Surface Pro) runs on Intel chips and full Windows 8. In order to make producing, rather than just consuming, content easier, it added a keyboard that doubles as a protector, an idea originally developed by the Asus Transformer (although with the Transformer, the keyboard doubles as an extra battery and connection hub).

This puts the Intel version of the surface in more or less direct competition with the new 'ultrabook' category of notebooks (smaller, sleeker but yet fully featured notebooks based on the Apple MacBook Air design) pushed by Intel. But Intel won't be too upset as its chips are inside. It is probably less amused by the cheaper surface running on ARM design chips though.

But does Microsoft have to make its own tablet for that? It kept many people in the dark, even long-time partners like Acer were caught by surprise, and they weren't amused. Here is Oliver Ahrens, Acer's Senior VP and President for Europe, Middle East and Africa, telling Reuters that Microsoft's strategy to take on Apple with the Surface will fail:

"I don't think it will be successful because you cannot be a hardware player with two products," he said to Reuters. "Microsoft is working with two dozen PC vendors worldwide, including the local guys, whereas Apple is alone, it can more or less do what it wants. Microsoft is a component of a PC system. A very important component but still a component."
Instead of focusing on Windows 8, the software giant has started a whole new war with Apple, and the products—and partners—will suffer, Ahrens said. [Cnet]

The tablet market is certainly attractive, and with Windows 8's optimized for touch navigation out later this year, the time seems ripe for a killer Windows tablet. Technology observer John Dvorak had another take on the Surface said:

First of all, nobody is coming to bat with a Windows 8 tablet and Microsoft knows it. The iPad rules the scene and no one else will do much more than fool around with variations on a theme, mostly using Android. The closest anyone has come, it seems, is Samsung with its Galaxy Note, which isn't really a tablet, but a huge phone. The space is moribund and so Microsoft jumped in.

The real reason, according to Dvorak, is that Microsoft simply needs a compelling product for its Microsoft retail stores, which it is opening at a fast rate:

The Apple stores, if you haven't noticed, account for the incredible success of the company over the past few years. They bring in a whopping $4,000 per square foot in annual retail sales, topping perennial sales star Tiffany & Co. The 363 stores in 13 countries move products like crazy—and Microsoft has noticed. It needs stores and branded products, period.

While the design of the Surface is certainly noteworthy with its stand, magnesium unibody, full-HD screen and keyboard/protector, there are questions over its price (which will be very important, see below), battery life, and connectivity. So it's difficult to say whether this product will take off.

How urgent Google wanted to enter this market itself (rather than just provide the free operating system Android) becomes clear from the following from Google's Andy Rubin:

Google reportedly only gave Asustek Computer Inc (OTC:AKCPF) four months to build the tablet. Couple that short timeframe with the fact that tablet had to sell for right at $200 along with demands of building something from a massive company like Google, and you can see why this was a tall order for ASUS.
It's also worth noting that Ruben says the tablet is sold at cost. "When it gets sold through the Play store, there's no margin," Rubin said. "It just basically gets (sold) through." [Dailytech]

It seems to have done a pretty nice job though. The price ($199) and the form factor (7 inch screen) seems much more designed to take on Amazon's 7 inch tablet, the Kindle Fire, which, at the same $199 selling price, is sold at a loss (but needless to say, Amazon makes up for this in sales, as the Fire is simply a marketing tool and shop window for its products and services).

So the Galaxy 7 is sold at cost. Well, on top of the operating system, which is also free. Apparently, tablets are a portal to other, more profitable services. Therefore, one reason is to expand the reach of Google ads, its core (and most profitable) business. However, Android has been found wanting in terms of seamless service offerings:

Rubin talked about the lackluster sales of Android tablets overall saying that the missing piece to the puzzle of why Android tablets weren't selling well initially was that they lacked an ecosystem. He says that Google lacked a full complement of TV shows, movies for purchase, magazines, and other content people expected on the tablet. "I think that was the missing piece," Rubin said.

An important, perhaps the most important, reason for both Google and Microsoft is to simply copy the vertical model of Apple, in order to create a seamless, compelling experience. Indeed, the new Nexus tablet reserves a prominent place for Google Play, Google's online app store that also has music, books, magazines and TV shows (but only in the US for some). You will even get some free with your Nexus 7 purchase.

This point wasn't lost on others either:

More and more, Android devices summon key elements of their user experience from the mother ship's computers—the Google search engine, maps, and much more. For every improvement in Jelly Bean that makes a device better on a stand-alone basis, there are many tweaks that tie it to the power Google's immense data resources. Mobile search, for example, combines a variety of services that non-Google mobile devices simply can't match (yet). [The Guardian]

Speaking about Jelly Bean, the new version of the Android operating system, this is another way in which the Galaxy 7 will have a head-start versus other Android tablets. It's also somewhat curious that Google didn't engage Motorola (which actually produced its own tablet, the Xoom) for building this tablet. After all, that is now also part of Google.

Both Google and Microsoft risk driving out third-party hardware producers for their tablets. Google's Nexus tablet is priced at costs but at least other hardware producers can get the Android operating system for free. No such luck for the hardware producers contemplating tablets running on Windows 8.

This puts Microsoft in a difficult position. It has a certain margin (it can simply forgo it profit margin for Windows 8 on its own tablet), but setting the price high to make Windows 8 tablets an attractive position for the likes of Nokia and others could risk losing the battle with Apple, Android, and Amazon. Setting a low price in order to compete with other integrated (or even subsidized) tablet ecosystems won't be attractive for third party hardware producers to expand into the Windows 8 tablet space.

The fact that both Google and Microsoft went for this integrated model with full force, even making little or no profits on the hardware itself shows that these companies strongly believe in the integrated approach. These tablets are ways to favorably position not only proprietary services such as Google ads, Google Play, Google search, and Microsoft's legacy business software, but also Skype (part of Microsoft), Bing, it's search program, and Internet Explorer, on a new and fast growing platform.

In order to compete in this space, they have to go vertical and squeeze margins, as well as provide a more seamless experience with services. If they upset third party vendors in their space, so be it. The latter—Samsung, Dell and Acer—seem to be the main casualties here.

Since we don't know much about the Surface's pricing (the Pro version is supposed to be in ultrabook territory), there is another possibility:

Will Microsoft end up competing with its customers? Not if it only builds high-end, high-margin products designed to sell at retail by a sales force. [Dvorak]

Therefore, it could mean that Microsoft won't be cannibalizing its third party hardware producers such as Google.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.